Putin Wants a Russian Commodities / Metals Exchange. Now.

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Includes: DBB, KOL, RSX
by: Craig Pirrong

Wednesday Putin did his best King Canute impression, and ordered a group of financial regulators, including the finance ministry, to draft plans for an exchange to trade steel, coal, coking coal, and other metals. By 1 August. Putin believes the exchange will, in the words of the Moscow Times article just linked to, “avert price rows between producers and industry.”

In other words, even though no exchange anywhere has created successful spot or futures markets for steel and coking coal, and really for thermal coal either, in the 150 odd years since the advent of modern futures trading, Putin has commanded that Russia, which has never really created a successful commodity exchange for anything ever, do it in less than 2 months.

Yeah. Right.

My reference to Canute was a slight to Canute, of course. The Danish (English/Norwegian/Swedish) king knew that he couldn’t make the waves cease their beating: he just wanted to make the point to court sycophants. Putin, by contrast, apparently thinks that his command will make it so. I can just imagine the furtive and panicked looks between those in Putin’s audience charged with implementing the (impossible) task. I can also imagine the “jump? how high boss?” responses to his command.

This is another case of Putin, Man in a Hurry, as I dubbed him soon after I began this blog. It is clear that he has tired of the squabbling between the upstream and downstream firms in the Russian ferrous metals sector. He evidently believes (or at least hopes) that a command that a market magically appear will relieve him of mediating this conflict to maintain the equilibrium in the natural state.

Ain’t gonna happen. Markets don’t just magically appear. As has been documented in the academic literature, most notably by Dennis Carlton, auction type futures markets are devilishly hard to start. Far more contracts fail than succeed, despite the concerted efforts of experienced exchanges to identify the most promising candidates, to work to design contracts that will suit the needs of the target industry, and to build industry support through favorable fees, liquidity support programs, etc.

Steel and coking coal are particularly challenging for a variety of reasons. ”Steel” is not a homogeneous product, but consists of a dizzying array of differing physical types and shapes. Some kinds of steel, e.g., scrap, are fairly standardized and traded, but its prices don’t necessarily track the prices and values of other types of steel. Coking coal is also characterized by substantial differences in grades and uses. Moreover, for coal in particular, location matters because it is relatively expensive to ship.

Industry structure matters too. Futures markets tend to work best with relatively disaggregated value chains, where the same product is often bought and sold repeatedly, and where there is relatively little concentration on either the buy or sell sides. (Structure is not independent of product characteristics, of course. Relatively homogeneous goods tend to have a larger number of buyers and sellers, and greater turnover, than more specialized goods unique to one producer or tailored to fit the needs of a particular consumer.)

Firms in an industry will not necessarily support the introduction of more transparent pricing mechanisms, either, as Carlton points out in another paper. The steel industry has been quite outspoken in criticizing plans for steel and iron ore derivatives markets. (India’s Tata Group is a good example of this.)

I would imagine all these factors go double in Russia–if not more than double. With central planning, the absence of a free pricing mechanism, and a preference for giganticism, Soviet firms tended to be few in number and dependent on a small number of suppliers and customers. Moreover, just as was the case with the U.S. electricity business prior to deregulation, integration and price regulation led to patterns of investment in plant and equipment that tended to create holdup problems; Steel plant S was highly dependent on coking coal from mine M because the lack of freely negotiated prices meant that outside options weren’t that valuable in constraining opportunism. (In U.S. electricity, firms that supplied both generation and transmission didn’t worry about holdups between these two stages of the value chain, and hence created generation and transmission infrastructures that were subject to bilateral monopoly problems when the products were unbundled in deregulation.) Russia inherited this structure, but then eliminated the central planning and price control that was necessary to keep transaction costs in check. Hence Putin’s pricing problems.

In Russia, the holdup problems inherent in the mismatch between the pattern of capital investments made when government control over prices suppressed (but didn’t eliminate) pricing disputes, and the pattern that firms would choose if they had to worry about opportunism problems, has exacerbated the price conflicts that are vexing Putin. But the problem is that saying “presto, change0, make me an exchange-0″ doesn’t make these fundamental problems go away. Indeed, they are antithetical to the effective operation of a centralized spot or futures market. And what’s more, the prices for the stuff not traded on exchange–which would be most of the steel and coal products actually produced and consumed in Russia–would still have to be negotiated between the parties. Yes, centralized market prices would provide some information about the underlying fundamentals that affect the values of steel, etc., but there would still be considerable room for dispute about the price relationships between the standardized and non-standardized products. As a result, there would still be considerable potential for holdup.

I would imagine this plan will go nowhere, as it is as futile as commanding the tides to stop. It is futile because it ignores all of the transaction- and product-specific features of the products in question, and the necessity of structuring transactions in ways that respect these features. Putin is apparently like Gary Gensler, who thinks that auction markets should be good for everything, when experience (and economics) shows that they are really good for very few things indeed and pretty much unworkable for everything else.

Putin’s heavy metal headache is a fitting curse for a Sovietophile who is enamored with raw materials and basic industries and who has been the enemy of property rights and the rule of law. He is suffering this malady in large part because of (a) an industrial structure inherited from Soviet times, and (b) the inability of Russia to move beyond its resource focused development, which (c) reflects in no small part the fact that the precariousness of property and legal rights in Putin’s natural state is an anathema to entrepreneurship and tends to favor the persistence of oligarchic structures. That's because oligarchs can bargain with the state on relatively equal terms, and can thereby protect themselves against expropriation without having to rely on courts. Putin’s problem, then, is inherent in Putinism.

Irony can be a real b*tch.

So, good luck with that steel exchange thing, VV. And don’t say I didn’t tell you so.